Tuesday, September 6, 2016

Preparing for a Stock Market Correction

“Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.” – Peter Lynch

I have observed investors for many years. The current bull market has been hated a lot, based on my observations with investors. I have often heard from someone that they are accumulating cash “because the market is too high” for 8 years in a row now. Some of these investors may have realized that it is difficult to find many quality companies available at bargain prices. I understand their frustration, because it has gotten really difficult to find quality companies to buy.

However, some have taken this frustration, and sold their stocks. The rationale for selling includes the fact that many stocks are very overvalued. Unfortunately, this is not a good rationale. Stocks can continue to stay overvalued for a while. On the other hand, the companies may appear to be overvalued because of short-term weakness or one-time events. If earnings were to rebound, stock prices may end up appearing fairly valued. Some recent headwinds faced by US companies include the strong dollar, which hurts foreign profits. Another includes the low oil price, which has depressed earnings in the energy sector.

I believe that the urge to do something is bad for long-term investors. Perhaps, this is due to the fact that you are not comfortable with holing too much in stocks and you need to dial down your equity exposure. Or perhaps, you are a speculator who thrives on action, even if it is detrimental to your long-term goals and objectives. It is possible that you do not understand long-term investing, and how it works. Reviewing stock market history may be helpful to you in this case.

As a long term investor, I make money when I buy a collection of businesses at a fair price, and then those businesses earn more money, pay higher dividends, all of which results in higher price for that business. The price of the business fluctuates all over the place, but the value should go up over time.

This has been the winning formula for long-term investing success in the stock market for decades.

The nice part is that few are willing to patiently hold on to stocks for decades, without succumbing to the myopia of looking at useless minutiae such as economic forecasts, quarterly reports, scaremongering newsletter salespeople or the media. The goal of all of that “noise” is to get you scared, and to engage in some activity that will enrich the broker, but could cost you thousands of dollars of lost opportunity costs.

In order to avoid a 10% - 20% correction, many of these people ended up missing out on 50% - 100% - 200% gains since 2009. Whether the next 50% move is up or down – that I don’t know. But since no one else knows either, I do not understand when investors position themselves as if they knew. I buy and hold, because I believe that a patient long-term owner of productive assets will profit. This means I will sit through corrections. This means I will stay the course.

I operate under the assumption that the money I invest in the stock market is there to be invested for the long-term. I know I will have a 20% year correction every couple of years or so, and a 40% - 50% correction perhaps once per decade. I invest for the next 30 years, which is why I should not care that the quotations will go down in the short run. And they likely will go down at some point. The problem is that few people know that in advance. And most who sell high, may miss out on buying “low”, because they are waiting for even lower prices. This is why I save money to invest every month, rather than accumulate cash hoping for lower prices which may or may not materialize.

It is true that we may get a big correction of 30% - 40% at some point in the future. But then things will likely rebound, and proceed higher. Over time, things could get better, earnings could improve, dividends will grow.

So in retrospect, if you sell a stock today because it looks overvalued, you may be correct. But you are taking some risks with those actions.

One risk you are taking is that earnings could rebound, and that the stock price and dividends could follow. So you may have missed out, while still paying a decent chunk of your gains to the friendly taxation office nearby.

It is also possible that the stock just hangs in there, while earnings and dividends slowly increase, until it starts going up. If you are paid to wait, why should you rush in and out like a speculator?

It is also possible that you are right that you should sell. But then the risk is that you may end up purchasing another investment that drops in value as well. You may also buy low too quickly at the first sign of a dip in prices, only to see heavy losses, and regret. Or if you stay in cash, you may miss putting the money to work, because you were waiting for even lower prices. I believe that the bull market of the past seven years has left many investors who patiently waited in cash behind

I operate under the expectation that a diversified portfolio of common stocks should do fine over the next 20 – 30 years. It is quite possible that we will witness some calamities, recessions, bear markets.

I also believe that investors who trade in and out of stocks are costing themselves money, and compounding mistakes. This is why I believe patience is the name of the game. Few investors can time markets, stock trades well.

My competitive advantage is being long equities, and holding on to them tightly.

I believe that this is the winning strategy for me for the next 30 years. I will let everyone else time entries and exits perfectly. I will just sit tight, let earnings and dividends grow, reinvest those dividends, and hold on tight.

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